Louis Capital Markets

Dealer/broker tailors platform for macro clients

Originally published in the September 2010 issue

Sell side research is in the doldrums. Substantial cuts in research budgets have narrowed the service offering, while questions about the credibility of sell-side recommendations linger. Increasingly, advice on trading strategies is being offered to hedge funds as independent agency broker-dealers look to monetise high quality research through trade execution.

At Louis Capital Markets (LCM) in London, Cyril Castelli, a veteran macro portfolio manager with French hedge fund ADI Gestion, is targeting macro funds with innovative research and trading strategies. The track record, encapsulated in a hypothetical book that LCM runs to communicate trading opportunities to hedge fund, pension fund and insurance clients, is showing annualised gains of about 20% since launch in May 2008.

Now, however, LCM is calling a turn in the market. Its models are giving strong signals of an imminent upswing in equities over the remainder of 2010 against a backdrop of over-bought bond markets. “The timing of the call is becoming urgent in terms of getting out of bonds and going into equities,” Castelli told The Hedge Fund Journal in an interview at LCM’s City base in Wood Street in late August.

The last big call Castelli’s team made was in April when it went long Treasuries further out on the curve and bought credit protection, while having a modest short on equities. Its reward was a thumping 10% gain in May during a period when hedge funds overall had their biggest losses since the fourth quarter of 2008 and some macro funds suffered 10% drawdowns.

“For the rest of 2010 the aim is to get short of fixed income and increase risk exposure primarily through being long G7 equities,” he says.

Global balanced allocation
LCM combines a global balanced asset allocation model with macro trading and tactical/relative value as satellite strategies to create the model macro portfolio. “The way we see global balanced is top down asset allocation rather than securities selection,” Castelli says. “The big question we try to answer is: do we want to be long risk. If yes: then, where and how.”

The focus is on analysing the development of the business cycle with a mix of qualitative and quantitative views of the market. On the quantitative side, the aim to identify the macro drivers of different asset classes using research from central banks and other sources. Liquidity and cyclical factors are also assessed. The idea is to build tools that will send signals to time the medium term investment cycles of different asset classes.

“I felt during my trading years that such a desk to service global macro funds didn’t exist,” Castelli says. “You could find risk arbitrage desks, event driven desks and a lot of other dedicated desks, but nothing for global macro mandates. The fact this was lacking and that sell side research was lacking transparency in terms of idea generation and follow through gave me the idea of the virtual global macro book. The product tries to add value through an objective decision making process and have transparency in the follow up.”

Signals from the models are screened to see how they align with what leading indicators are showing about the business cycle. The idea is to come out with a target portfolio based on a view of where the business cycle is and then compare it with the market. If there is a gap a trade is constructed; if there isn’t, no trade is undertaken.

“If we agree with what the market is pricing, there will likely bevery little risk exposure,” says Castelli. “But if there is a big gap opening up between what we believe is the most likely scenario and what the markets are pricing in, we will construct a trade to exploit this.”

Mid cycle slowdown called in April
In April, LCM felt that a mid cycle slowdown was imminent and that three major risks – a US economic slowdown; the impact of the sovereign crisis on European banks lending behaviour; and slowing Chinese economic momentum – were being underpriced by investors. In early September, Castelli believes the opposite call needs to be made.

“Today we feel, on bonds, that valuations have become extremely expensive,” he says, noting that the fair value model on US Treasuries and other G10 bonds is giving its most over valued reading since record keeping began.

LCM reckons that fair value on the US 10 year bond is closer to 3.75% rather than the 2.62% that prevailed on 1st September. But valuation is only part of the calculation. Technical and cyclical factors, including economic momentum indicators, combine to create a risk index which LCM uses as a compass on different asset classes. All three are now showing extremely high risk on government bonds. On a technical reading, the bond market looks heavily over bought: the deviation from the 100 week moving average in US and Europe is at its second greatest level in 50 years – the greatest deviation occurred the week after Lehman Brother collapsed.

Need for macro expertise
The changed market landscape post-2008 has seen many event driven and equity long/short funds bring in macro expertise to help portfolios better navigate a very tough market landscape.

Castelli says the volatile market conditions have fuelled demand for LCM’s service, not only among global macro funds but among multi-strategy players. He believes that any institutional investor with a dynamic portfolio allocation strategy, including sovereign wealth funds, can benefit from what LCM is offering.

The LCM model macro portfolio holds a position for an average lifespan of around three months and makes about 50 trades annually. Each time there is a trade, a notification email is sent to clients. The idea is to make it easy for clients to track what is inside the book. Different tactics are used to enhance different strategies. This might see carry used or volatility preferred when it is attractively priced or relative analysis undertaken to find the best trade for a particular investment view. The idea is to develop strategies that can maximise returns from a conviction at a given time.

“It may not be about putting a specific trade in their books, perhaps just pointing out dangers or giving a way of expressing views to managers,” says Castelli. “There has been a huge banking research legitimacy crisis. It first happened in 2000. Now there is another one with the sub prime meltdown. The lack of transparency and the subjectivity of the global banking research started a trend where independent research is beginning to be valued more than it was.”

“Our message is that we think we can add value,” Castelli says. “If only once or twice a year we can bring something new to the table and help a manager lose less or make more, we would feel we have fulfilled our mandate. This year we pushed fixed income when no one wanted to hear about it. We are about to make another call now.”

“Investors are looking at honesty and transparency in their research providers: honesty in terms of follow up and transparency in terms of how you came with an idea,” says Castelli.

“This is where we want to be positioned. The crisis made everyone realise that you can’t escape macro risk. It is always on your book. But people brushed it aside because returns were so good for so long. The idea that you could neutralise the top-down macro risk completely blew up. People realised that with the sub prime crisis and now with the sovereign crisis that macro isgoing to be here for a long time.”